CFNAI: Headline Disguises The Supply/Demand Imbalance
At the beginning of June I wrote an article titled "The Most Important Economic Number" in which I discussed an article that had been written by Russ Koesterich, CFA, who is the iShares Global Chief Investment Strategist. The point of that article is that the Chicago Fed National Activity Index, which is a composite index made up of 85 subcomponents that gives a broad overview of overall economic activity in the U.S, is often ignored by the mainstream media which could be a mistake. The reason is that unlike backward-looking statistics like GDP, the CFNAI is a forward looking metric that gives some indication of how the economy is likely to look in the coming months.
The overall index is broken down into four major sub-categories which cover:
- Production & Income
- Employment, Unemployment & Hours
- Personal Consumption & Housing
- Sales, Orders & Inventories
To get a better grasp of these four major sub-components I have constructed a 4-panel chart showing each of the individual subcomponents as compared to a major economic indicator. As you can see there are historically some very close comparisons between the major economic indicators and the underlying sub-index of the CFNAI.
While all four subcomponents clearly show the sharp post-recession rebound; it appears that each have also reached the mature stage of the current economic cycle. However, the lower-left quadrant showing housing starts as compared to personal consumption and housing really stood out. One of the primary arguments for the continuation of the "economic recovery" story has been the support derived from residential housing. However, within that housing component, the most critical is housing starts. Existing home sales and permits have little economic impact with respect to the amount of activity generated by the construction of a new home. From architects, to engineering, to construction and completion the building of a new home has the biggest economic multiplier of them all. The problem, as shown in the chart above it appears that housing starts may have peaked for the current economic cycle.
Furthermore, in regards to economic impact, Personal Consumption Expenditures (PCE) is by far the most important as it comprises roughly 70% of the GDP calculation. It is clear that PCE peaked in 2011 and has been reflected in continued sub-par economic growth. This has been the story of the last few years, which has continued to confound and baffle the Federal Reserve, as to why successive rounds of monetary interventions has done little to spur real economic growth. However, the CFNAI has been clearly showing a "struggle through" economy which is shown in the chart below which compares the CFNAI with its 6-month average.
However, to really understand this conundrum a bit better let's look at the CFNAI a little differently. If we break up the sub-components into two different categories, "supply" and "demand", we can get a better look at what is likely to drive future decisions by business owners. As a business owner myself; I can tell you that businesses will only increase production, and employment, when they feel confident about future customer demand to support the higher related costs associated with any expansion.
In this regard we can look at the CFNAI as customer "demand" and business "supply." The subcomponents of "Consumption & Housing" and "Sales, Orders and Inventories" most adequately reflect customer demand while business supply is represented by "Production & Income" and "Employment, Unemployment and Hours." The chart below shows the 3-month average of the "business supply" and "customer demand" indexes. Do you see the problem here?
It is important to notice that historically the demand side of the CFNAI has always led the supply side. This is exactly as it should be as demand drives production. However, unlike every previous cycle, the demand structure is not only lagging the supply since the end of the last recession - it is still at levels that is normally consistent WITH recessionary lows. It is highly unlikely that if consumption, sales and orders are not sufficiently rising that businesses will be able to sustain higher levels of production and employment for very long. It is most logical that the current divergence will be filled at some point by either a sharp resurgence in consumer demand or a slowdown in economic activity. Historical evidence currently suggests the latter.
What we have seen over the past few years have been repeated "soft patches" in economic activity that have led to short term bursts of "restocking" activity. However, the overall trend of the economic data post the recessionary trough has been negative with each bounce in activity hitting lower highs and setting lower lows. After a very sluggish economic environment in the last half of 2012 we are currently seeing, once again, a bounce in economic activity. However, these upticks in the economic data in the past have been mistakenly reported as a return to economic growth. Given the weakness in the "new orders" component of virtually every manufacturing report as of late it is unlikely that this time will be different. The chart below, which is the Economic Output Composite Index, shows this declining trend of "soft patches" and "recoveries" since the end of the last recession. (For a description of the underlying construction of the index click here)
The divergence between the supply and demand sides of the economy clearly explain the broader issues. For businesses it will be very difficult to continue to commit capital to expansion, production or employment without demand being substantially increasing. Furthermore, the overhang of higher tax rates, reduced government spending and the impact of higher costs from the "Affordable Care Act" all weigh on business investment and spending decisions.
With profit margins under attack as revenue growth slows as cost cutting has reached its effective limits; companies are having to resort to "labor hoarding" and temporary employment to maintain current production levels and profitability as costs continue to rise. The NFIB recently summed up the current sentiment of business owners in their latest survey stating:
"It's a bad situation in Washington, scandals, no budget deals, no dealing with the big problems, our own government agencies taking advantage of us, Congressional law being suspended by the President, a flood of executive orders, the threat of higher energy costs (the attack on coal). Not a good time to bet on the future by hiring lots of workers with uncertain cost...Economic growth was revised down for the first quarter of the year and the outlook for the second quarter is not looking good. Nothing cheers up a small-business owner more than a customer, and they remain scarce and cautious while consumer spending remains weak and more owners are reporting negative sales trends than positive ones. It certainly doesn't help that the endless stream of delays and capitulations of certain provisions of the healthcare law adds to the uncertainty felt by owners. Until growth returns to the small-business half of the economy, it will be hard to generate meaningful economic growth and job creation."
The gap between demand and supply in the latest CNFAI report goes to the heart of what the NFIB has been stating repeatedly since the last recession ended. Despite government reported economic data and artificially inflated asset prices - "Main Street" is still operating as if they are in a recession.